When offshoring boosts local jobs

Most studies on the effects of offshoring on domestic labour and productivity are skewed because they focus on larger firms, but the inclusion of SME's reveals a counterintuitive reality.

How offshoring affects the home economy, particularly home employment and inequality, has been a hot issue in policy circles in many developed countries. Theoretically, the employment and wage effects of offshoring can go either way, depending on how offshoring affects domestic productivity and technology.

Empirically, existing studies often find that the effects of offshoring on the size of domestic employment are either negative but quantitatively small, or positive. This is probably because offshoring is often found to improve productivity at home. The productivity effect could mitigate the possible negative employment effect of offshoring. In addition, many empirical studies find evidence showing that offshoring has raised wage inequality between skilled and unskilled workers and demand for skilled labour.

New evidence from Japanese small and medium enterprises

In recent research, I add new evidence on these issues using Japanese firm-level data. The contributions of this study are twofold. First, it particularly focuses on small and medium enterprises (SMEs). As more and more SMEs are going to engage in offshoring, and as SMEs create much of domestic employment, how SMEs’ offshoring affects their domestic employment should be of great interest to policymakers.

However, most firm-level data used for research on offshoring are restricted to relatively large firms, due to data availability. For example, in the case of Japan, researchers often use data which consist of firms with 50 workers or more. By contrast, the panel data I used in my recent research consists of 1,511 SMEs with a median number of workers of 38.

Second, estimation of the effect of offshoring on employment is often biased due to possible reverse causality, ie, a possible tendency that larger firms are more likely to engage in offshoring. This reverse causality from employment to offshoring can blur causality from offshoring to employment, unless we carefully examine data. Although existing studies have tried a number of tools to extract causation from correlation, I employ a unique method, using characteristics of chief executive officers (CEOs). In particular, the study uses risk and time preferences and overseas experiences of CEOs, which are rarely available in firm-level data. It is found that these characteristics of CEOs affect offshoring decisions significantly, as they affect exporting and FDI decisions. Since such characteristics of CEOs of Japanese SMEs are more likely to be determined prior to their decisions on offshoring, they can be used as instruments in two-stage least squares estimations which can correct for biases due to reverse causality.

My results indicate that offshoring of Japanese SMEs does not necessarily reduce domestic employment. Although there is a positive correlation between offshoring and the change in the number of workers (Figure 1), this correlation is due to causality from employment (firm size) to offshoring, not causality from offshoring to employment. When endogeneity is controlled for, the effect of offshoring on the number of workers is statistically insignificant. This is also the case when we distinguish between intra-firm and arms’-length offshoring and look at the effect of each type of offshoring. I also find that SMEs engaging in offshoring increases the share of workers with a bachelor’s degree by about 20 percentage points. Finally, I find weak evidence that offshoring of Japanese SMEs improves their productivity level. The productivity improvement is most likely to be a source of no negative effect of offshoring on home employment.

Figure 1. Average number of workers

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An anecdote from an article in the newspaper Nikkei on November 3 2011 supports these results. Japan AMC, an SME producing metal parts for construction in a small provincial city, set up a plant in China in 1997 and in Thailand in 2006 to offshore much of its production processes. However, the number of their workers increased from 70 in 1997 to 143 in 2011. According to the Nikkei article, this is because offshoring improved the competitiveness of Japan AMC and thus expanded its sales, and because its headquarter needed more workers for the management of globalised production processes and technical assistance to offshored production sites, ie., more skill-intensive tasks.

Policy implications

Economists have already accumulated much empirical evidence on the effects of offshoring. Although the results vary, many of them, including my own for Japanese SMEs, indicate no large negative effect on domestic employment, and positive effects on productivity and demand for skilled labour. One policy implication from these results is that policymakers in developed countries should not worry too much about losses of domestic employment due to offshoring. The evidence suggests that unskilled jobs are offshored and replaced with skilled jobs in the home country, leading to more productive use of the domestic labour force.

However, this is not the end of the story. The evidence also suggests that policies should help to upgrade knowledge and skills of domestic workers. Otherwise, unskilled workers in developed countries would lose their jobs, as offshoring shrinks unskilled jobs and expands skilled jobs.

One possible policy measure in the case of Japan is to reform universities, as the tertiary enrolment ratio of Japan exceeds 50 per cent while the quality of most Japanese universities remains low. For example, among the top 200 universities in the world, only five are in Japan, compared with 12 in Germany where the population is about half of Japan’s. Also, Japanese universities are often less globalised. The average share of foreigners among faculty members was only 5 per cent for Japan in 2010 (Ministry of Education, Culture, Sports, Science and Technology of Japan), while the corresponding share for many top universities in the world exceeds 20 per cent (Times Higher Education). Although it is still unclear how policies can provide resources and incentives for skill upgrading, vitalising and globalising universities should help Japanese workers to upgrade their skills to mitigate the possible negative effects of offshoring on inequality.

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